Back in 2001, Warren Buffett had talked about the Mcap to GDP ratio as probably being one of the best measures of valuation. On a top down basis this is one of the indicators that he tracked to identify extremes of market irrationality. Like all valuation indicators there certainly are limitations to the measure. And in pursuit of perfection one could make multiple adjustments to make the measure more robust. But as Buffett puts it “On a macro basis, quantification doesn’t have to be complicated at all”.
Can we apply this measure to the Indian Market?
We have used publicly available data from BSE (MCap) and RBI (Nominal GDP) to check whether the indicator has any predictive value. We have tried to arrive at the 5 year prospective return from the equity market based on Mcap/Nominal GDP ratio at a given point in time. The prospective return has been arrived at using Long term Nominal GDP growth (10 year rolling CAGR) and the assumption that Mcap/Nominal GDP ratio would revert back to Mean by the end of the 5th Year. In the chart below, the blue line represents the 5 year prospective return arrived at using above method, the orange line represents SENSEX total return (Price return + Dividend yield) and the grey line represents BSE 500 Total return. The actual return ends up being higher than indicated prospective return if at the end of 5th year the Mcap/GDP ratio is above long term average and vice versa.
In some years there has been major gap, for example in 2010 the model had indicated a prospective return of ~5.5%, while both SENSEX and BSE 500 delivered a compounded total return of 11%. Such a big gap compounded for 5 years would be big. But directionally it might give you a good indication of prospective return and help in setting your expectations right.
How are we placed today?
Based on the current Mcap/GDP ratio, the 5 year prospective return is ~8.5% (as of 22 Jan 2018). In context of 5 year risk free Government bond yield of 7.2%, the spread seems narrow. Thus it is better to sober down the Equity return assumptions for the next 5 years and have a relook at the asset allocation.